Under the 2017 Tax Cuts and Jobs Act, Congress enacted a new Section 199A 20% profit deduction for owners of pass-through businesses, and which include Subchapter S corporations, LLCs, sole proprietorships, and even certain trusts. Section 199A is intended to provide a deduction to owners of these pass-through business entities who do not otherwise benefit from the new 21% flat tax Congress has given to corporations under the new tax law. While Section 199A is intended to benefit these generally smaller types of business entities and their owners, the new tax law is riddled with complexity and exceptions, and so that many well-meaning small business owners may not receive the deduction, or at least its full amount.
The new 20% profit pass-thru deduction has raised many questions from owners of rental real estate. Can owners of rental real estate qualify for this important deduction, and under what conditions?
The IRS released final regulations under Section 199A on January 18, 2019. On the same date, the IRS also issued Notice 2019-07 providing guidance on the applicability of the Section 199A deduction to rental real estate activities. In this notice, the IRS announced a “Safe Harbor” under which rental real estate enterprises would be treated as a “trade or business” for purposes of qualifying for the new Section 199A deduction. The new guidance importantly notes that if certain rental real estate activities do not fall within the scope of the new Safe Harbor, the activities may still qualify for the deduction if the activity otherwise can satisfy the general requirements of the new regulations.
For a rental real estate enterprise to qualify as a trade or business under this new announced Safe Harbor in Notice 2019-07, the following requirements must be met:
- Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise;
- For taxable years beginning prior to January 1, 2023, 250 or more hours of “rental services” must be performed each year with respect to the rental enterprise. For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), at least 250 hours of rental services must be performed annually with respect to the rental real estate enterprise; and
- The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services (this “contemporaneous records” requirement does not apply to tax years beginning prior to January 1, 2019).
For purposes of the Safe Harbor, “rental services” include (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. Importantly, the guidance provides that qualifying rental services may be performed not only by owners but also by employees, agents, and/or independent contractors of the owners.
There are exceptions and exclusions under this new announced Safe Harbor for rental real estate activities under Section 199A. For example, the guidance states that real estate used by a taxpayer as his residence, and real estate leased under a “triple net lease” (where the tenant is required to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities), are specifically not subject to the Safe Harbor.
The new Safe Harbor announced by the IRS provides helpful guidance now to owners of rental real estate. Some owners may find the 250-hour requirement to be challenging, although hours of rental-related activity can include not only those of the owner, but also all rental-related hours of employees, agents, and also independent contractors of the enterprise. Finally, if rental activity does not come within the specific requirements of the Safe Harbor, the IRS has announced that the activity may seek to otherwise establish itself as a qualifying trade or business under the final regulations for purposes of the Section 199A deduction.
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